Off-Balance Sheet Financing:
An Explosive Situation?
An Honors Thesis (ID
49~
by
Michael H. Bozymski
Thesis Director
I
Ball State University
Muncie, Indiana
November, 1985
Expected date of graduation (Autumn/198~
gf~""
I
l"",
"
;..I'
1-1 ~ . . .:
-- .i.
OFF-BAIJANCl,,; SH1~l~':r FIN ANC ING:
AN F,XPL03IV t!: S I:rUATION?
IN'rQODUCTION
statement of the Problem
Off-balance sheet debt may be the biggest mystery in
corporate finance.
It is impossible to estimate the amount
of money owed by U.S. corporations '''hich is not recorded in
their books.
pensior_
Besides the hundreds of billions of unrecorded
obli~ations,
companies use these borrowings for things
as small as office plants, and as large as oil refineries.
The reason for not showing these obligations on the balance
sheet is simple--nast experience has
sho~m
that this practice
helps imnrove the appearance of a company's financial position. 1
HO':vever, this method can also backfire on the company.
Sometimes an investor will overestimate a company's off-balance sheet debt 1;lhich in turn makes the firm appear less
att~acti ve.
This has been found to exist ,,'hen off-balance
sheet leases are estiMated by the factor method. 2
As the
amount of off-balance sheet debt continues to grow, it is
important to take a look at it to make sure that the situation is not out of hand.
The purpose of this paper is to
examine the effects, both beneficial and detrimental, of offbalance sheet financing.
Reasons for Increase in Off-Balance Sheet Financing
Why has off-balance sheet debt increased recently?
In
2
the past, quality companies sold stock or fixed-income bonds
to raise capital.
They did not deal with warrants or adjust-
able-rate notes. '3
However, recent changes in economic and
business conditions, as well as tax laws, have led companies
to develop new means of
raisin~
dous benefits to the borrowers. 4
capital which offer tremenCorporate finance is now
applaucing innovation and crea ti vi ty.
T~ven
top-name compa-
nies such as American Airlines and GM are employinE?; practices
usually related to unseasoned companies.
In addition to
traditional securities offerings, these large companies are
devising new twists in lease agreements, and leaving the tabs
of new plants and buildings for the customer to pick up.5
Blue-chip companies that once looked d01tm upon off-balance
sheet schemes are now using them due to the irresistable
.
. .ln t eres t cos t s. 6
savlngs
ln
PAS.TICIPANTS IN OFF-BALANCf;
Co~panies
SHB"~T
FINANCING
such as GM are not the only new players
entering the off-balance sheet financing game.
Other play-
ers include the public, insurance companies, and the bank.
The public is playing the role of equity participant as well
as lender.
Insurance companies which traditionally sought
long-te-m fixed-income commitments, are now favoring agreements with built-in inflation protection.
At the same time,
banks, realizing that there is money to be made, are competitively seeking the project financing business from topnotch corporations.?
TYPES OF OFF-BALANC;;;
SHE~T
]<'INANCING
Numerous financing mechanisms that do not show up on the
balance sheet as debt have been tried.
8.ppear to be the most popular. 8
Out of these, leases
Companies may wi sh to lease
assets instead of borrowing the money to purchase them because of the following reasons:
it protects against the
risk of obsolescence, it does away with maintenance and servicing problems, and it can qualify for tax benefits.
A
number of firms believe that leasing provides them with more
financial leverage compared to debt financing.
Since some
leases are structured so that they do not have to appear on
the balance sheet,
co~p8nies
believe that investors will some-
times ignore these off-balance sheet liabilities.
Likewise,
companies realize that certain investors will attempt to add
these obligations back into total debt, but will underestimate them. 9
The company is still provided with more finan-
cial leverage.
Investors are not the only ones who under-
estimate these lease liabilities.
A recent study showed that
a large number of bankers and analysts believed that a company
having off-balance sheet leases was more profitable than a
company having the exact same obligation on the books. 10
On the other hand, keeping leases off of the balance
sheet could decrease a company's debt capacity.
Although
this situation does exist, few firms ever consider it.
~hen
investors look at a company with such leases, they may overestimate them when adding the leases back into total debt.
4
This would make the firm appear less attractive than if it
1.ilould have capitalized its lease obligations and included
them on the balance sheet.
The end result of this could be
a possible increase in borrowing costs and a decrease in
available credit to the company.11
Product Financing Arrangements
Product financing practices are another common type of
off-balance sheet financing.
An example of this is when a
company sells its product, but agrees to buy it bad<:: at a
subse~uent
date.
In the past, it was acceptable for the seller
to reccrd this transaction as a sale and not acknowledge any
related obligation.
This would overstate the seller's sales
and understate his obligations on the balance sheet.
Product
finqncing arrangements are characterized by the fact that
the sponsor retains the ris1\:s and rev.fards of ovming a product,
while the buyer is looked upon as holding legal title to
allow for financing for the sponsor's benefit. 12
FASB stepped in
~ith
In 1981 the
Statement of Financial Accounting Stan-
dards No. 49, "Accounting for Product Financin,o; ArL'angements".
The FASB believes that transactions similar to the one above
arc borrowing transactions and not sales.
TherefoL'e, the
seller should record a liability for the amount of cash received.
Also finance and carrying costs, such a,s interest
and insurance, are to be recorded as accrued expenses when
incurred by the seller.
All product financing arrangements
occurring after June 15, 1981 must conform to this state1')
mente "
5
T3E
METROM~DIA
CASE
One of the more recent examples of using off-balance
sheet financin,;s to improve a company's financial statements
involves the case of Netromedia Inc.
Metromedia, engaged in
the areas of entertainment and communication, sold the main
assets of its outdoor advertising business in 1982.
the
purchaf:e price ',·ras a :'70 million note and;'A 15 million in
cash.
~:2~7
Prior to this sale Metromedia had a cash deficit of
mi Ilion.
It is highly unlikely that they could have
borrowed an amount comparable to B485 million at a fair rate.
Thanks to the "s21e" they obtained financing of almost~~')OO
million and
reali~ed
above transaction!
a profit of nearly 1200 million on the
However, since l'1etromedia plans to buy
back the assets in 1987, this transaction should not have
been recorded as a sale. 14
This is clearly a case of off-
balance sheet financing.
P}WBL:~~1S
idITH ACCOUNTING CONCSPTS
An important iS2,ue 'I.'i th regards to off-balance sheet
financing concerns the objectives of financial reporting.
Does off-balance sheet financing meet these objectives?
Ac-
cording to statement of Financial Accounting Concepts No.1,
"Objectives of Financial Reporting by Business Snterprises",
financial statements should provide investors, ,creditors,
and other users with useful information to allow for the making of rational decisions concerning investment and credit.
Furthermore, financial reporting should provide information
6
which is evenhanded and neutral.
Focusing on off-balance
sheet financing, the statement says that reporting should
supply information about the obligations of a business to
transfe-" resources to other busine8ses or o'rmer' s equi ty.
This information is of utmost importance for investors and
credito~s
who wish to measure the financial strengths and
'tleaknes::;es, as '.'Jell as the licluioi ty and solvency, of a
company. 15
!Ihen a company leaves some of its de b t
the balance sheet, creditors and investors alike
led.
off of
~ay
be mis-
Because of the understatement of obligations the com-
pany may a,ppear to be stronger financially.
A company that
does not include such debt on the balance sheet is not fully
meeting the objectives of financial reporting.
Next
~e
must consider if the use of off-balance sheet
debt impairs some of the qualitative characteristics of accounting information.
A central theme to accounting is that
the information presented should be reliable.
This means
that the information represents what it proposes to represent, and that the user of the information has some type of
assurance.
The characteristic of completeness is included
in reliability.
'~hich
Completeness states that all material items
are necessary to validify that the information repre-
sents the supporting events are to be included.
completeness is also necessary for relevance.
Likewise,
If a relev8nt
bit of information if left out of the statements, the relevance of the entire statements is affected.
Thus complete-
ness is required for the two main qualities (reliability and
relevance) that make accounting information useful. 16
7
Financial statements that understate a cOTTlpany's liabilities
due to off-balance :"heet debt are not considered complete,
nor are they considered reliable.
The use of off-balance
sheet financing produces accountinG information which lacks
certain desired Qualitative characteristics.
n~N~FITS
T~e
bi~gest
OFF-BALANC~ SH~~T
adv~mtages
Tho:;
ous.
OF
FINANCING
of off-balance sheet fina.ncing are numer-
companies that use these techniques seem to be the
beneficiaries.
To begin with, off-balance sheet fi-
nancing improves the appearance of a company's financial
statements.
Also, a company in poor financial condition oan
aouire funds through these schemes that it probably could not
obtctin from a bank.
The case involving f,letromecUa serves as
a testimonial for this.
Another advantage for companies is
that they can often times save money by using off-balance
sheet f:Lnancing.
borro':!er
\1.'1
These techniques sometimes provide the
th a lo"ver interest rate than that of the banks.
Companies are not the only ones benefiting from off-balance
sheet financing.
are
get"~ing
Banks, insurance companies, a nd the public
involved and making money from such arrangements.
m~TRn1BNTS
OF OFF-BALANCE SHBET }'INANCING
Along '}li th the benefi ts of off-balance sheet financing
come certain dis8.dvantages.
A. major disadvantage or detri-
ment, is that certain users of financial statements may be
misled if the company has off-balance sheet debt.
may overestimate the
~ell-being
An investor
of such a company, or a bank
8
mi.O'ht make a loan 1.vhich the company has little chance of
'-:J
rep8yin~.
Unless the users of financial statements take the
off-balance sheet neht into 8ccount, it is highly likely
that they will not be able to properly assess a c08pany's
condition.
Perhaps the greatest detriment of off-balance
sheet financing is that it contradicts some of the basic concepts of accounting, as "Tell as certain authoritative pronouncements.
A basic concept requires companies to supply
information about their obligations.
Off-balance sheet debt
often times disre,r;ards this concept.
I,ike\'lise, a company
th?t enters into
(3
product financing arrangement and does
not rec8rd an ohligation, is disregarding Statement of Financial Accounting Standards No. 49.
COiJCLUSION
Off-balance sheet financing plays a major role in corporate :: inance.
A company that uses such financing can
acquil'e many benefits.
These benefits include improvement
of the appearance of the financial statements and possible
reductions in borrowing costs.
However, there are detri-
ments to off-balance sheet financing.
Some companies are
using such techniques to blatantly mislead users of their
fin8.ncial st8.temen ts.
Y'lore importantly, some of these prac-
tices completely cisregard certain accounting conce1)ts and
auttori~ative
pronouncements.
I feel that the detriments of
off-balance sheet financing outweigh the benefits.
In con-
clusion, I believe th8t off-balance sheet financing has gotten
out of hand, and certain measures must be taken to insure
9
proper disclosure of corporate
obli~ations,
before the users
of financial statements lose all faith in them.
1.
Her~3hman, Arlene, "Ne"j Games in Off-Balance Sheet Financin<s," ~)un's Business r'lonth, v. 119, February, 1982, p. 56.
2. Houlihan,iJilliam A. and Ashwinpaul C. Sondhi, "UeFacto
Capitalization of Operating Leases:
The ~ffect on Debt Capacity," Corporate Accounting, v. 2, Summer, 1984, p. 7.
Hershman, Arlene, Lynn Adkins and G. Bruce Knecht, "Creati VE! Ne1,r Lool<: in Corporate Hinance," Dun's Review, v. 118,
July, 1981, p. 28.
7,.
4.
t::
"
.
Hershman, p. 56.
Her:3hman and others, p. 28.
6.
Her:3hman, p. 57.
7.
Ibid, pp. 56-57.
8.
Ibid, p. 56.
9.
Houlihan and Sondhi, pp. ")-4.
10.
Hershman, p. 56.
11 •
Houlihan and Sondhi, p. 4.
12 • .Fioriti, Andre"! A. and Stephen I. Wellborn, "Accounting
for Spe~ialized Product Sales," Virginia Accountant, v. '~4,
September, 1982, pp. 32-34.
1 ~~.
Fin3.nchl.l Accounting ~~tandards Board, Statement of Financial Ac~ounting Standards No. 49, I1Accounting for Product
?inancing Arrangements," Stamford , Connecticut:
FASB, 1981.
14. Briloff, Ab-::,aham J.,
Au gu s t ,3, 1 985, P • ~ 2 •
"T'~ore
on
~,'letromedia,"
Barron's,
15.
Fin3.ncial Accounting Standards Board, statement of financial Accounting 80ncepts No.1, "Objectives of Financial Reportlng by 3usiness:<~nterprises," Stamford, Connecticut:
FA~)B,
1 97 e f s 2 c. .) ::: - . 4 1 •
16.
Financial Accounting Standards Board, Statement of Financial Accounting Conceuts No.2, "Qualitative Characteristics
of Accounting Information," Stamford, Connecticut: FASB,
1 97e, sec. .059-. oeo.
BIBLIOGRi\PffY
Briloff,. Abraham J., "More on f,1etromedia," Barron's, August
8, 1983, pp. 32-34.
Financial Accounting Standards Board, Statement of Financial
Accounting Concepts No.1, "Objectives of Financial
Reporting by Business Enterprises," Stamford, Connecticut: FASB, 1978.
Financial Accounting Standards Board, Statement of Financial
-Accounting Concepts No.2, "Qualitative Characteristics
or Accounting Inform?tion," Stamford, Connecticut:
FASB, 1980.
Financial Accounting Standards Board, Statement of Financial
Accountin~ Concepts No.3, "Elements of Financial Statements ofusiness Enterprises," Stamford, Connecticut:
FASB, 1980.
Financial Accounting Standards Board, Statement of Financial
Accountin 9 Concepts No.5, "Recognition and Measurement
Tn Financlal Statements of Business Enterprises," Stamford, Connecticut:
FASB, 1984.
Financial Accounting Standards Board, Statement of Financial
Accounting Standards No. 13, "Accounting for Leases,"
Stamford, Connecticut: FASB, 1976.
Financial Accounting Standards Board, Statement of Financial
Accounting Standards No. 47, "Disclosure of long-Term
Obligations," Stamford, Connecticut:
FASB, 1981.
Financial Accounting Standards Board, Statement of Financial
Accounting Standards No. 49, "Accounting for Product
'FInancing Arrangements," Stamford, Connecticut:
FASB,
1981 •
Fioriti, Andrew A. and Stephen I. Wellborn, "Accounting for
Specialized Product Sales," Virginia Accountant, v. 34,
September, 1982, pp. 32-34.
Hershman, Arlene, lynn Adkins and G. Bruce Knecht, "Creative
Kew look in Corporate Finance," Dun's Review, v. 118,
July, 1981, pp. 18-3'), 32.
Hershman, Arlene, "New Games in Off-Balance Sheet Financing,"
Dun's Business l\1onth, v. 119, February, 1982, pp. 56-57,
bOo
Houlihan, William A. and Ashwinpaul C. Sondhi, "DeFacto Capitalization of Operating leases: The Effect on Debt Ca12 acit y," Corporate Accounting, v. 2, Summer, 1984, pp.
3-·13.